So, Um, What Is A Private Equity Firm?

by: January 19, 2012

In the run-up to Saturday’s GOP presidential primary in South Carolina, candidates have clashed over the role of Bain Capital — a firm that either creates or kills jobs, depending upon whom you believe.

Front-runner Mitt Romney sees the bright side. Before entering politics in the 1990s, he co-founded Boston-based Bain Capital, one of the nation’s largest and most profitable private equity funds. He has said he created 100,000 jobs while at Bain.

But critics say that figure excludes the legions of workers who were laid off by Bain. Candidate Rick Perry described Romney’s work as “vulture” capitalism. And former House Speaker Newt Gingrich repeatedly raised questions about the firm’s approach to job-cutting.

Before this controversy erupted, most Americans had never heard of Bain. That’s because it operates in the private investing world, not the public market.

In the public arena, anyone can turn to say, the New York Stock Exchange, and buy shares of a publicly traded company. But in the private equity investing world, only wealthy individuals and large institutions, such as pension funds, are welcome. That’s Bain’s world. Here’s how it works:

What is a private equity firm?

This term describes companies like Bain, which gather up funds from wealthy individuals or institutions for the purpose of buying up companies and turning a profit, usually within four to seven years. The equity firm’s managers get fees, as well as about 20 percent of the gross profits.

A typical deal goes something like this: The equity firm buys a company through an auction. The firm then increases the value of the company by, for example, upgrading its accounting system, procurement process and information technology, or by laying off workers and closing unprofitable operations.

After the private equity firm gets the company in better shape, it exits the deal by selling it to a large corporation or offering stock to the public. But often the effort to fix up the company fails and bankruptcy is the outcome. The rewards can be huge, but the risks are great too.

So why is this controversial?

Sometimes, the private equity firm uses strategies that critics say play out more as “vulture capitalism” — a phrase that some people are using to describe a process where investors make enormous profits while needlessly laying off workers.

The Wall Street Journal did an analysis of the 77 businesses Bain invested in during Romney’s tenure. It found 22 percent either filed for bankruptcy or shut down within eight years of Bain’s investment. Even several companies that initially provided Bain with huge profits later ran into trouble. Of the 10 deals that produced more than 70 percent of Bain’s gains, four eventually filed for bankruptcy.

But the companies that succeeded were hugely profitable. The Journal concluded that Bain turned $1.1 billion in investments into $2.5 billion in gains in the 77 deals.

The phrase “leveraged buyout” is sometimes used in connection with private equity firms. What is that?

“Leverage” refers to large amounts of debt. Just as a lever can be used to help lift a heavy load, borrowed dollars can help lift a deal that otherwise wouldn’t happen.

Defenders say the deals can work well. For example, if a company is headed for bankruptcy anyway, an infusion of borrowed money may be a life preserver. The cash can be used to buy equipment, upgrade software or offer severance pay to unneeded employees.

In the end, the spruced-up company can be sold to a larger corporation, or it can start selling shares in a public stock market. The profits can be used to pay off old loans and reward the investors. Critics say the strategy too often results in needless layoffs that do little to actually save the company.

What is venture capitalism?

That’s another strategy for investing private funds. In this scenario, the equity firm provides capital (money) to a startup venture and then helps support the small company as it grows.

The private equity firm hopes to make lots of money from successful startups, but the investors are taking bigger risks than bank lenders would be willing to take.

We’ve also heard about “crony capitalism.” What’s that?

In a capitalist system, success is supposed to be determined by the free market and rule of law. But Perry’s critics say that in Texas, he has been promoting “crony capitalism,” where the relationship between business and the state is too close. Under crony capitalism, the success of a particular business is dependent on the favoritism shown to it by the government, in the form of tax breaks, grants and other incentives. Perry’s spokesman has denied the governor has engaged in inappropriate business dealings.

President Obama also has been accused of crony capitalism in relation to his support for Solyndra, a failed company that specialized in green energy technology.